What Rhymes With “Transitory”?
Fed Chair Jerome Powell officially renounced the term “transitory” last week amid mounting political pressures to recognize that prices keep rising. But understanding the economic forces driving inflation requires staring deep into the data and making big assumptions about epidemiology and human behavior. If we’re looking for a new term to describe current price dynamics, we’re still better off sticking with synonyms for impermanent, ephemeral, or peaking.
Recent data hasn’t been kind to this view, as higher prices are no longer contained to sectors that have reopened after lockdowns. They can’t be chalked up to energy prices alone. They are beginning to show in short-term price expectations.
The argument turns murky fast because the timing and terms are rarely well-defined. But those of us who worry less about inflation mostly look for long-term inflation to settle near 2% by the end of next year, with the Fed hiking rates slowly and predictably as the recovery continues.
If you’re a long-term investor, the central inflation question is whether the pandemic’s damage to labor markets and the massive policy response have fundamentally altered the 40-year trend that has kept inflation at bay and set interest rates on an ever-lower trajectory. Aging demographics in rich countries have dampened demand, while globalized labor markets and relentless technological advances have kept pay rises in check.
Of course, we’ve never seen so much government spending and central bank liquidity injected at the same time. And we’re still trying to understand if we will ever get back those 5 million American jobs that disappeared during the pandemic. The combination has sent the U.S. consumer price index soaring to 6.2% for now, but it’s still a stretch to imagine these forces will drive inflation sustainably above the 2% target that central banks have failed to meet for decades.
Labor Force Participation Rate
16 Years + (NSA, %)
Source: Bureau of Labor Statistics. As of December 2, 2021.
Source: Bureau of Economic Analysis. As of December 2, 2021.
As for shorter-term, it’s important to exclude the extremes from the debate.
Those who worry about persistent price increases don’t necessarily predict a return of the wage-and-price spirals of the 1970s, when consumer price inflation was in double-digits. They understand that an OPEC oil embargo is just as unlikely as general strikes for higher pay. Some even concede the longer-term disinflationary pressures will eventually return.
Among those of us who believe inflation will begin to dissipate in the first part of next year, few would deny that short-order cooks face their best job market ever or that supply chain disruptions may last through next Christmas. They know it’s more expensive to rent an apartment, and they see the rising prices of homes, food, and crypto assets.
The crux of the current debate, however, is much simpler. Is the Fed behind the curve? Will it hike rates more than twice next year, as markets now predict?
The inflationistas see prices rising everywhere and worry the trends will embed themselves into self-fulfilling prophecies as companies pass along rising input costs to consumers, who, as workers, will pass along higher living costs to companies. But the team formerly known as “transitory” believes the supply-and-demand dynamics that have been so disruptive this year are, in fact, trans—, uh, unlikely to persist next year.
Supply chains may not return to normal any time soon, but the sharp and unexpected spikes in demand that triggered the current chaos won’t be repeated. Some workers are gone for good, but many will have run down savings enough to return to work. Yes, there will be more pandemic variants to manage, but the world does in fact learn to manage challenges over time.
The Organization for Economic Cooperation and Development just sounded the alarm about inflationary pressures, but even its higher forecast of 2.5% late next year represents a sharp fall from current levels. Will the Fed really look “behind the curve” if all those inflation numbers are edging downward by summer?
Even if price expectations start drifting higher next year, the Fed will be wary of those longer-term disinflationary forces it has been battling for so long. It may start to talk up a more hawkish line as Powell did in his Congressional testimony last week, but it will be reluctant to raise rates faster than it absolutely has to.
Omicron concerns aside, the economy still looks poised for a snappy recovery with buoyant consumer demand, healthy corporate profits, and banks that have plenty of money to lend. These may even shift the battle lines so that by the time we reach the second half of next year a third hike may not look so frightening. Indeed, given the amount of money that has been pumped into the economy over the last two years, it would be much more troublesome if we were not moving to normalize policy by then.
But more likely than not, inflation will be fading as a risk to the recovery. Prices will continue to rise and interest rates will rise with them, but the Fed won’t be forced into a mistake that snuffs out the recovery before its time.